The Digitization of Risk Management and Insurance

Martin J. Frappolli, CPCU, FIDM, AIC, is Senior Director of Knowledge Resources at The Institutes, and editor of the organization's new “Managing Cyber Risk” textbook. He can be reached at [email protected]

When I think about insurance, I usually regard it as just one tool in the risk manager’s tool box. When a person or organization is faced with risk that carries a significant financial consequence, the prudent response is to begin to find ways to avoid or mitigate the risk. Often, the final step is risk financing — transferring the risk by insurance.

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Sometimes, though, insurance is more out front in managing risk. Workers’ compensation insurance is a great example. When states began passing workers’ comp laws in the early part of the twentieth century, employers sought to insure that cost, and insurers responded with workers’ compensation insurance policies.

The wonderful upside was that insurers quickly understood that they had a financial interest not only in helping injured employees recover and return to the workplace, but also in the prevention of accidents. So many of the leaps forward in workplace safety can be attributed to the motivation of employers to obtain good workers’ comp coverage at favorable rates.

In the early days of indoor heating and plumbing, boiler explosions were common and disastrous. Here again, the boiler insurers were the driving force behind safety standards that dramatically reduced the frequency of boiler explosions. The insurance wasn’t just a tool for the risk manager, but a force for innovation in risk management.

We can turn from those early examples to the modern waves of technology that are poised to change the world of insurance and risk management. Some are simple and easy to grasp; why should a claims adjuster ever again climb onto a roof to inspect hail damage when high-resolution images can be taken better, faster, and cheaper by a drone?

Insurers have a long history of capturing, storing, and processing data related to exposures and losses. With all the new external data generated by the Internet of Things, new methods of data storage become essential.

Perhaps even more promising are the advances tied to new ways of data generation/capture, data storage, and data analysis. The huge waves of data produced by devices on the Internet of Things offer insurers and risk managers information not previously available. For example, a tractor-trailer can be equipped with sensors that monitor engine oil and temperature, tire pressure, load factors, even the alertness of the driver. While these data points are useful for rating and underwriting, the most promising aspect is the value of the data for loss prevention. Much like the early days of workers’ comp and boiler insurance, every party to the insurance transaction has a deep interest in preventing accidents.

Insurers have a long history of capturing, storing, and processing data related to exposures and losses. With all the new external data generated by the Internet of Things, new methods of data storage become essential. Cloud storage isn’t brand new, but this decentralized technology enables efficient and affordable methods to organize the volumes of new data. More cutting edge is Blockchain technology, which enables storage of smart contracts that can automate a lot of otherwise labor-intensive processes in underwriting risks and settling claims.

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My favorite insurance Blockchain example is index insurance for crops. Consider a farmer in a remote part of the world whose entire crop is worth $500. No insurer would ever visit to underwrite nor send a claims rep to investigate a loss. But now the farmer can insure his crop for $500 via index insurance, which pays out if there is a verifiable event that would destroy the crop, such as drought or flood. By a smart contract agreement stored in a Blockchain, an independently-verifiable source could confirm the weather event and automatically trigger the loss payment. Not only is the farmer saved, but Blockchain enables a new class of business not previously viable for the insurer.

Of course, all the new data with the new storage techniques require advanced data analysis techniques to turn data into actionable information. Smart insurers are already embracing these new tools for data capture, data storage, and data analysis. The good news is that these technologies don’t only make insurance more efficient, but that they offer a new path to better risk management.

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You conducted a feasibility study before forming your captive, establishing long term goals and objectives, determining which risks to write, where to domicile, and how to finance it all.

But that was five years ago.

Since then, your company has made two acquisitions, expanded its workforce, implemented new technology, contracted with new suppliers, and been affected by a new federal regulation. In short, the risk profile has changed considerably.

Is your captive keeping up?

“As with all other business matters, your company’s captive needs and goals are likely to change over time, especially with new and emerging risks sprouting up frequently,” said Karin Landry, managing partner, Spring Consulting Group.

“We recommend a ‘refeasibility’ study at least every five years to reassess risk appetite and exposure.”

A ‘refeasibility’ study ensures your captive insurance company is still serving your organization’s needs and furthering its mission, rather than holding it back. Unlike the initial feasibility study, this periodic checkup must consider your existing captive structure and financing strategies, and take into account how the captive has performed thus far.

To gain a holistic view of your captive’s performance and evaluate the need for change, captive owners should ask themselves these five questions:

1. Do your captive’s goals align with your risk profile?

Karin Landry, Managing Partner, Spring Consulting Group

Evaluating your captive’s goals in the first step of a refeasibility plan. And that begins with collection of data. Claims experience, reserve and surplus levels, loss ratios and other measures of efficiency indicate how successfully the captive has operated and where it has underperformed.

This indicates whether it has met initial goals, and whether those goals should change. This decision is also largely dependent on changes in the insured organization’s risk profile and the subsequent impact on insurance needs.

Moving employee benefits into a captive may be a more efficient way to provide coverage for a larger payroll. Greater reliance on automation or IoT technology may likewise increase the need for cyber coverage tailored to an organization’s specific needs.

“Emerging risks should be considered in this assessment,” Landry said. “For example, new technologies like driverless cars and drones and increasing automation will create both risks and opportunities across various industries.”

Performance metrics can help risk managers identify areas where resources can be shifted to support the coverage needs demanded by organizational change and emerging risks.

2. How will proposed changes impact other parts of the captive company?

The second stage of the study considers how adjustments to long term goals affect other pieces of the captive puzzle, such risk financing and use of reinsurance.

Adding new lines of coverage or expanding or reducing existing ones will necessitate an evaluation of risk financing strategies and could lead to changes in an organization’s investment mix or retention levels. This may also impact reliance on reinsurance as a component of the overall risk transfer strategy.

The best way to pinpoint the extent to which these changes should be made, Landry said, is through stress-testing.

“Running through scenarios with reasonable adverse case outcomes highlight where more or less financing is needed to service claims and maintain favorable loss ratios,” Landry said.

3. What specific implementation strategies will make your changes stick?

As with any enterprise-wide change, a detailed roadmap lays the groundwork for successful outcomes and can gain the confidence of stakeholders.

This stage identifies lines of insurance that could be moved into the captive or other coverages that would be more cost effective to insure through the traditional insurance market. Along with cyber and employee benefits, some of the most common risks to insure in captives include professional liability, auto liability, reputation, and business interruption.

Capital management strategies should also specify how surplus will be used going forward.

“There are several considerations in appropriately managing the capital and surplus levels over the life of a captive, including average cost of capital, retention levels, reinsurance use and taxes, among others,” Landry said. “A team of actuaries and consultants could review and develop strategy to address these.”

4. Does your existing captive structure still work?

Captives have taken on a number of different forms since their inception — single parent, group/association, rental captives, sponsored captives, non-controlled foreign corporations, etc. The primary differences between these structures center on the way risk is shared among the parties involved and how the captive is financed and regulated.

Sponsored captives, for example, offer a way for companies to take advantage of the established infrastructure of a traditional insurer and avoid the upfront costs of forming a captive — though they are not accepted in all domiciles. Group captives allow companies with unrelated risks to spread out their exposure and reduce their total cost of risk, but can present management challenges.

A captive’s domicile, the scope of risk it seeks to cover, and the financial strength of its parent company all help to determine which structure will work best.

5. Does your captive account for recent case law and regulations?

The technology industry isn’t the only one that is always changing. Laws, regulations and court cases, especially lately, have an impact on captives and need to be considered as you are taking a fresh look at your strategy.

Firstly, there’s tax reform. The tax rate reduction under the Trump administration has had a direct impact on captives, and a consolidated tax return that includes a captive insurance company should have its tax sharing agreement reviewed.

Further, payments to a foreign captive should be reviewed to determine if the Base Erosion Anti-Abuse Tax (BEAT) is applicable, and anyone in the U.S. with an owner’s interest in a foreign insurance company needs to review their holdings. IRS Notice 2016-66 with respect to microcaptives should also be considered, which leads us to our next point.

In light of two recent court cases – Avrahami vs. Commissioner and Reserve Mech. Corp. v. Commissioner – we now have more insight into what the IRS believes to be the criteria for a bona fide insurance company. As a result, we recommend going through a checklist of sorts to ensure the following regarding your captive:

Is the captive created for a non-tax business reason?

Is comparable coverage available in the market?

Are the policies valid and binding?

Domicile-related regulations are also changing. Is yours compliant with your current domicile, and have you looked at the new domiciles available? Lastly, it’s imperative to take a look at the Dodd Frank Act, specifically the self-procurement tax to ensure your captive is appropriately aligned.

6. Are the changes having the effect they’re supposed to?

You’ve identified new opportunities for your captive, supported proposed changes with data and stakeholder feedback, and developed detailed and holistic plans to move forward. But you’re not done.

The final step of any refeasibility study is to measure outcomes. Collect data again to see if newly established goals are being met and how the rest of the captive organization has been impacted.

“A great deal of this stage relies on solid industry benchmarks against which to measure current and future captive performance,” Landry said. “Furthermore, it’s important that the optimization team takes this data and edits their implementation plan accordingly to keep captive performance on track, making actionable recommendations for staff to follow.”

To execute your plan, turn to expert help

“These findings should serve as a baseline for measurement going forward,” Landry said. But look for a team of experts ranging from employee benefits, risk management and actuarial services to walk you through the steps and, ultimately, implementation. This is especially important as new risks continue to emerge and evolve; routine maintenance on your captive is important, just like it is on your car!

This article was produced by the R&I Brand Studio, a unit of the advertising department of Risk & Insurance, in collaboration with Spring Consulting Group. The editorial staff of Risk & Insurance had no role in its preparation.

Spring Consulting Group, an Alera Group Company, LLC is a Boston-based employee benefits, risk management and actuarial consulting firm with clients across the globe.

A growing number of Americans earn their living in the gig economy without employer-provided benefits and protections such as workers’ compensation.

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With the proliferation of on-demand services powered by digital platforms, questions surrounding who does and does not actually work in the gig economy continue to vex stakeholders. Courts and legislators are being asked to decide what constitutes an employee and what constitutes an independent contractor, or gig worker.

The issues are how the worker is paid and who controls the work process, said Bobby Bollinger, a North Carolina attorney specializing in workers’ compensation law with a client roster in the trucking industry.

The common law test, he said, the same one the IRS uses, considers “whose tools and whose materials are used. Whether the employer is telling the worker how to do the job on a minute-to-minute basis. Whether the worker is paid by the hour or by the job. Whether he’s free to work for someone else.”

Legal challenges have occurred, starting with lawsuits against transportation network companies (TNCs) like Uber and Lyft. Several court cases in recent years have come down on the side of allowing such companies to continue classifying drivers as independent contractors.

Those decisions are significant for TNCs, because the gig model relies on the lower labor cost of independent contractors. Classification as an employee adds at least 30 percent to labor costs.

The issues lie with how a worker is paid and who controls the work process. — Bobby Bollinger, a North Carolina attorney

However, a March 2018 California Supreme Court ruling in a case involving delivery drivers for Dynamex went the other way. The Dynamex decision places heavy emphasis on whether the worker is performing a core function of the business.

Under the Dynamex court’s standard, an electrician called to fix a wiring problem at an Uber office would be considered a general contractor. But a driver providing rides to customers would be part of the company’s central mission and therefore an employee.

Despite the California ruling, a Philadelphia court a month later declined to follow suit, ruling that Uber’s limousine drivers are independent contractors, not employees. So a definitive answer remains elusive.

The motive for companies seeking the contractor definition is clear: They don’t have to pay for benefits, said Meneghello. “But from a legal perspective, it’s not so easy to turn the workforce into contractors.”

“My concern is for individuals who believe they’re covered under workers’ compensation, have an injury, try to file a claim and find they’re not covered in the eyes of the state.” — Matt Zender, vice president, workers’ compensation product manager, AmTrust

It’s about to get easier, however. In 2016, Handy — which is being sued in five states for misclassification of workers — drafted a N.Y. bill to establish a program where gig-economy companies would pay 2.5 percent of workers’ income into individual health savings accounts, yet would classify them as independent contractors.

Unions and worker advocacy groups argue the program would rob workers of rights and protections. So Handy moved on to eight other states where it would be more likely to win.

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So far, the Handy bills have passed one house of the legislature in Georgia and Colorado; passed both houses in Iowa and Tennessee; and been signed into law in Kentucky, Utah and Indiana. A similar bill was also introduced in Alabama.

The bills’ language says all workers who find jobs through a website or mobile app are independent contractors, as long as the company running the digital platform does not control schedules, prohibit them from working elsewhere and meets other criteria. Two bills exclude transportation network companies such as Uber.

These laws could have far-reaching consequences. Traditional service companies will struggle to compete with start-ups paying minimal labor costs.

Opponents warn that the Handy bills are so broad that a service company need only launch an app for customers to contract services, and they’d be free to re-classify their employees as independent contractors — leaving workers without social security, health insurance or the protections of unemployment insurance or workers’ comp.

That could destabilize social safety nets as well as shrink available workers’ comp premiums.

A New Classification

Independent contractors need to buy their own insurance, including workers’ compensation. But many don’t, said Hart Brown, executive vice president, COO, Firestorm. They may not realize that in the case of an accident, their personal car and health insurance won’t engage, Brown said.

Workers’ compensation for gig workers can be hard to find. Some state-sponsored funds provide self-employed contractors’ coverage. Policies can be expensive though in some high-risk occupations, such as roofing, said Bollinger.

The gig system, where a worker does several different jobs for several different companies, breaks down without portable benefits, said Brown. Portable benefits would follow workers from one workplace engagement to another.

What a portable benefits program would look like is unclear, he said, but some combination of employers, independent contractors and intermediaries (such as a digital platform business or staffing agency) would contribute to the program based on a percentage of each transaction.

There is movement toward portable benefits legislation. The Aspen Institute proposed portable benefits where companies contribute to workers’ benefits based on how much an employee works for them. Uber and SEI together proposed a portable benefits bill to the Washington State Legislature.

Meneghello is skeptical of portable benefits as a long-term solution. “They’re a good first step,” he said, “but they paper over the problem. We need a new category of workers.”

A portable benefits model would open opportunities for the growing Insurtech market. Brad Smith, CEO, Intuit, estimates the gig economy to be about 34 percent of the workforce in 2018, growing to 43 percent by 2020.

The insurance industry reinvented itself from a risk transfer mechanism to a risk management mechanism, Brown said, and now it’s reinventing itself again as risk educator to a new hybrid market. &

Susannah Levine writes about health care, education and technology. She can be reached at [email protected] Michelle Kerr is associate editor of Risk & Insurance. She can be reached at [email protected]

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